Inputs for a 409A

WRITTEN BY: CHARLES KEEPMAN

|||Inputs for a 409A

What is a 409A?

A 409A valuation is a type of business valuation performed to determine the fair market value of the common stock of a privately held company. This valuation is typically performed for the purpose of establishing the exercise price of stock options granted to employees or consultants of the company.

The 409A process can be divided into three steps: Valuing the overall business, allocating the overall equity value to each share class and applying the appropriate discount for lack of marketability.

Business Valuation: What are the main factors?

There are several key factors that are considered when valuing a business, and each of these inputs can have a significant impact on the final valuation conclusion. These factors include:

  • Company History: The company’s past financial performance and growth trajectory can provide valuable insight into its future potential. This information can be used to inform assumptions about the company’s future financial performance.
  • Financial Projections: Financial projections are used to anticipate the future financial performance of the company. These projections typically include estimates of revenue, expenses, and profitability over a period of time, in most instances 3 to 5 years. The more realistic and accurate the financial projections, the more reliable the valuation will be.
  • Market Conditions: The current state of the economy and the specific industry in which the business operates can have an impact on the value of a company. Factors such as industry demand, competitive landscape, and economic conditions can all influence the valuation. More specifically the multiples of publicly traded companies and the multiples derived from mergers and acquisitions.
  • Risk Profile: The level of risk associated with the company’s operations can also have an impact on the valuation. Companies that are perceived as being riskier may be valued lower than those that are perceived as being less risky. Some risks include, but are not limited to: competition, regulation, concentration (customer, geographic, product, etc.), operational and many more.
  • Valuation Method: There are several different methods that can be used to perform a business valuation, including the income approach, the market approach, and the asset approach. The chosen method or methods can differ based on the development stage, the industry, and circumstances of the business. Often times multiple methods are utilized in order to triangulate or corroborate the appropriate value.

Once the overall company has been valued the overall value is allocated to each security. The economic rights and preferences of each security are accounted for in a current value method for more simple capital structures and an option pricing model for more complex capital structures.

Security Allocation: What are the main inputs?

The current value method is used when the only outstanding security is common stock. In simple terms the overall equity value is divided by the number of outstanding shares of common stock. Option pricing models are a little more complex and incorporate several inputs in addition to the Black Scholes formula. These inputs include:

  • Risk Free Rate: The risk free rate is typically derived from U.S. Treasury bonds. In the past five years this rate has gone from a couple percent down to almost zero and back up to a few percent. There is not much subjectivity involved in this assumption.
  • Volatility: The volatility is calculated based on publicly traded companies historical performed tracked over a set time frame. The higher the volatility the higher the conclusion of the analysis.
  • Years to Liquidity: The anticipated time frame for the equity holders to receive liquidity. The higher the anticipated time to liquidity the higher the concluded result.

Once the value of common stock is derived the last step is to apply the applicable discounts for lack of marketability.

Discount for Lack of Marketability: What are the main inputs?

Several methods are used to determine the appropriate discount for lack of marketability. Besides benchmarking through restricted stock studies another common approach is to calculate various methods of put options, which are derived by using various inputs. These inputs include:

  • Risk Free Rate: The risk free rate is typically derived from U.S. Treasury bonds. In the past five years this rate has gone from a couple percent down to almost zero and back up to a few percent. There is not much subjectivity involved in this assumption.
  • Volatility: The volatility is calculated based on publicly traded companies historical performed tracked over a set time frame. The higher the volatility the higher the concluded discount.
  • Term to Maturity: The years anticipated before maturity often the years until an anticipated exit. The longer timeframe to maturity the higher the resultant discount.

In conclusion, the 409A process can be divided into three steps with various factors and inputs. Ultimately the value of a business and in turn each class of security can fall within a range of reasonableness. Each of these factors or inputs can have a significant effect on the final valuation conclusion, and it is important for valuators to consider all these factors and inputs in order to arrive at a reliable and accurate valuation.

2023-01-11T17:41:40+00:00